The management of interest rate risk should be one of the critical components of market risk management in banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk.
Interest rate risk in banking is the potential negative impact on the Net interest income and it refers to the vulnerability of an institutions financial condition to the movement in interest rates. Changes in interest rate affect earnings, value of assets, liability, off-balance sheet items and cash flow. Hence, the objective of interest rate risk management is to maintain earnings, improve the capability, ability to absorb potential loss and to ensure the adequacy of the compensation received for the risk taken and effect risk return trade-off.
Management of interest rate risk aims at capturing the risks arising from the maturity and re-pricing mismatches and is measured both from the earnings and economic value perspective.
The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities), expose bank’s NII or NIM to variations. The earning of assets and the cost of liabilities are now closely related to market interest rate volatility.
Earnings perspective involves analyzing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) equivalent to the difference between total interest income and total interest expense.
Economic value perspective involves analyzing the expected cash inflows on assets minus expected cash outflows on liabilities plus the net cash flows or off-balance sheet items. The economic value perspective identifies risk arising from long-term inteerst rate gaps.
In detail Interest Rate Risk in banking is the risk due to changes in market interest rates, which might adversely affect the bank’s financial condition. The immediate impact of change in interest rates is on the bank’s earnings through fall in Net Interest Income (NII). Ultimately the impact of the potential long-term effects of changes in interest rates is on the underlying economic value of bank’s assets, liabilities and off-balance sheet positions. The interest rate risk when viewed from these two perspective is called as “Earning’s Perspective” and “Economic Value Perspective”, respectively.
In simple terms, high proportion of fixed income assets would mean that any increase in interest rate will not result in higher interest income (due to fixed nature of interest rate) and likewise reduction interest rate will not decrease interest income. Low proportion of fixed assets will have the opposite effect.
Banks have laid down policies with regard to Volume, Minimum Maturity, Holding Period, Duration, Stop Loss, Rating Standards, etc., for classifying securities in the trading book. The statement of interest rate sensitivity is being prepared by banks. Prudential limits on gaps with a bearing on total assets, earning assets or equity have been set up.
Interest rate will be explained with the help of examples:
For instances, a bank has accepted long-term deposits @ 13% and deployed in cash credit @ 17%. If the market interest rate falls by 1%, it will have to reduce interest rate on cash credit by 1% as cash credit is repriced quarterly. However, it will not be able to reduce interest on term deposits. Thus, the net interest income of the bank will go down by 1%.
Or suppose a bank has 90 days deposit @ 9% deployed in one year bond @ 12%. If the market interest rate arises by 1%, the bank will have to renew the deposits after 90 days at a higher rate. However it will continue to get interest rate at the old rate from the bond. In this case too, the net interest income will go down by 1%.
Types of Interest Rate Risk in Banking
The various types of interest rate risk in banking are identified as follows:
- Price Risk: Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related. The price risk is closely associated with the trading book, which is created for making profit out of short-term movements in interest rates. Banks which have an active trading book should, therefore, formulate policies to limit the portfolio size, holding period, duration, defeasance period, stop loss limits, marking to market, etc.
- Reinvestment Risk: Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions.